Friday, September 14, 2012

We've seen past commentary from multiple managers on shares of Valeant Pharmaceuticals (VRX) and thought it was worth highlighting given that numerous respected managers own it.

Hedge Fund Activity

As of the end of the second quarter, prominent institutional owners of VRX include (in descending order): Ruane Cunniff, Jeff Ubben's ValueAct, Andreas Halvorsen's Viking Global, Glenn Greenberg's Brave Warrior, Lee Ainslie's Maverick Capital, and many more. In the past, VRX has also made Goldman Sachs' VIP list of most important stocks to hedge funds.

Weitz Funds Commentary

While this perspective on Valeant is from June 30th, it still gives a good background of the story/thesis.

The well known manager of the Sequoia Fund holds quite a large position in VRX that has appreciated in value over time. It initially started as a 6% position and has grown to a 10% position in the main fund. They were the largest institutional owner of VRX as of the end of Q2.

They addressed their stake during their investor day back in May of this year. Again, while dated, the comments still outline their rationale for owning shares:

"The reason that we still like Valeant is the reason we liked it in the first place. It is a pharmaceutical company that does not really function like a traditional pharmaceutical company. By that I mean most pharma companies, if you look at how much they spend on research and development might spend 10%, 15% or in the high teens as a percentage of sales on research and development. Last year Valeant did about $2.3 billion in sales and it spent $66 million on R&D, which is about 3% of sales. So instead of spending money on R&D, it spends money acquiring whole companies and/or products and other assets. And what it does is restructure those assets. So we think of it as a value investor in other companies or in the assets of other companies which are available for purchase.

The reason that Valeant can do that is that it has a good team at the top led by Mike Pearson, who has been an extraordinary and very aggressive manager. The types of returns that Valeant can generate by acquiring another company and cutting costs can be in the 15% to 20% range. Just to give you an idea of that, when Valeant merged with Biovail, Biovail was doing a billion dollars in sales, and management cut out — the year-end synergy target this year is $300 million to $350 million. Valeant is eliminating costs that represent 35% of sales. Because of the company’s tax structure, it pays taxes at very low rates. So a lot of that $350 million is going to flow through to the bottom line. You can generate huge returns if you do those kinds of deals. Last year Valeant acquired Ortho Dermatologics, Dermik, Sanitas, PharmaSwiss and a few other companies. In aggregate, these companies added another billion dollars in sales and the synergy target is $250 million. Again, a lot of that is going to fall through to the bottom line. So Valeant is generating really high returns by acquiring other businesses in the pharmaceutical industry.

One of the most attractive things about the company is that it is going to generate $1.3 billion in cash earnings this year and there are not many companies that can retain that amount of money and reinvest it at a rate of return of 15% to 20%, and we could potentially see Valeant doing that for a number of years. You can get a huge amount of growth if you can reinvest that amount of earnings at those rates of return. That is the main reason that we are excited about it."

Today we present a guest post from Barbarian Capital (follow them on Twitter as well) with the case for shorting English Premier League football club: Manchester United (MANU). Shares recently IPO'd and were priced at $14, below their expected range of $16-18. Since then, MANU has drifted down to $12.xx, where it currently trades.

If you found it unusual that one of the most storied teams in the history of soccer would do its IPO in the US, you’re not alone. MANU was rumored to be considering an IPO in Asia (as have a fair number of European luxury brands), and, yet, the deal was done in New York. This is akin to the NY Yankees IPOing in Moscow. The devil (pun intended) is in the details: Manchester United, founded in 1878, was able to qualify as an “emerging growth company” under the new JOBS Act that loosened the compliance requirements for smaller public companies. This is a clear case of regulator shopping and a major red flag, especially considering that the company is very well established and was publicly traded in the UK before the Glazer takeover. It is difficult to see an upside for the individual investor.

Major Corporate Governance Problems

There are a few points here. One is dual-class shares. While the Glazers want you to have all of the downside economic risk, they are keeping the high-vote Class B shares all to themselves. An outside investor cannot win from a dual-class structure, and there are plenty of abuse examples (NY Times, Dillards, Dover Motorsports, etc.) There is a large number of related party transactions, including, but not limited to Manchester United loans to the Glazers, consulting fees to the Glazers and the Glazers also being creditors to the club (they hold a certain percentage of the debt, obviously a conflict). Finally, only half of the IPO money went to the club for debt reduction. The other half was pocketed by the Glazers: if MANU has so much upside, why are they not keeping the shares?

The Competition is Irrational

Let’s spell it out: sports teams are billionaire hobby toys. They are not rationally run businesses: the owners will fund large losses due to expensive player contracts to win. Acquiring marquee players is a hamster wheel, year after year after year. As a shareholder in MANU, you are signing up to compete with the spending powers of Arab oil sheiks (i.e. Manchester City, current champions) or Russian oligarchs (i.e. Chelsea, a top 3 team over the last decade). Eventually, the enthusiasm runs out but we are not there yet in the major European and US leagues (we’re seeing it on the fringes, like the bankruptcies of the Glasgow Rangers in the Scottish Premiership or the Phoenix Coyotes in the NHL or the LA Dodgers in the MLB). Good businesses spend little on capital expenditures on an ongoing basis, bad businesses spend a lot every year. Unfortunately, players are not warrantied like a machine is. Here’s Manchester United’s spend:

Publicly-Traded Soccer Teams Record

The track record of publicly traded soccer teams is an unmitigated disaster. Here is something from Saxobank analyst Sverrir Sverrirsson.

Most of the teams have had negative IPO-to-now/IPO-to-end return. From the positive teams, two are in the English Premiership, so they rode the big media money wave from the 1990s/2000s when the EPL was getting established. I don’t know what to say about the Turkish teams (assuming the returns are in constant currency, not nominal Turkish lira returns). The performance of these IPOs is incontrovertible evidence (well, at least for me) that soccer team ownership is a hobby, not a business.

MANU's revenues are roughly split in 1/3rds: broadcast, commercial/sponsorships/licensing and attendance. All are close to peak, in my view.

Simply put, MANU is a very successful but already a very heavily monetized brand. Unlike their cross-town rivals Manchester City who just won their first title in 40-50 years or (expected) up-and-comer Paris Saint Germain, MANU is a true dynasty. Here is a look at their performance: ask yourself, can it get any better?

Since MANU does not control the TV contracts (those are handled by the English Premier League for the EPL games and UEFA for the UEFA Championship League; in total, MANU is available for viewing in 210 countries), MANU can control only the “highlights and behind-the-stages” mobile product, ALREADY available in 42 countries. The mobile product has grown nicely, now accounting for GBP 16mm after doubling for two years in a row. The EPL contract was re-signed in June 2012 (with MANU benefiting) and UEFA is sold country by country, so the danger of a blockbuster contract signing is low).

“Peak sponsorship” is the other problem. MANU has been aggressively growing the roster of sponsors (i.e. Smirnoff is their Asian “responsible drinking partner”, whatever that is; DHL is a “training kit sponsor”; etc.). The biggest chunk is the most visible sponsorship, the jersey. MANU’s revenue growth there is impressive:

But there is a MAJOR problem that I have not seen anyone in the mass media mention yet. Chevrolet will be their next jersey sponsor. However, GM’s head of marketing just got fired on the spot (!) over the MANU sponsorship deal, as he apparently tried to hide the true cost of the contract across a few accounts (until a whistleblower reported it). GM is one of the largest, most sophisticated ad buyers in the world, and if they balk at the MANU sponsorship costs, you can bet they are not the only ones.

MANU’s licensed products are already available in 130 countries, and are obviously very dependent on the team’s ongoing “star power”.

The final revenue stream is gameday attendance and related. The problem there is that attendance for their home games is has been at 99% capacity for the last 15 years. Future ticket increases will only worsen the already tense relationship between the unwelcome ownership group and the team fans. The stadium was expanded in 2006, and any further expansion will be coming from the shareholders’ pockets. The question is not only capacity: MANU already plays close to the maximum number of games at home. The EPL is one of the larger leagues in soccer, and the team usually advances pretty far in all other tournaments (UEFA Champions League, the Carling Cup, etc.).

Key Person Risk

MANU has exceptional key person risk. Right now, it is probably concentrated in their star strikers (no one pays to see a great defensive tackle) and their longtime coach, Sir Alex Ferguson. Injuries and the coach’s eventual departures will mean either worse results or big spending in the market to attract replacement talent.

Credit Risk

MANU carries GBP 360 mm in debt after the IPO proceeds. While not a crazy level of leverage, debt adds risk. The team paid a call premium to retire a portion of it with the IPO proceeds.

Guidance for FYE 6/30/2012 Is Poor

Under “Recent Developments” in their filing, MANU discuss a 3-5% revenue drop to GBP 315-320 mm due to fewer home games and lower UEFA TV revenue. EBITDA will be down 16-18% to under GBP 100 mm. Earnings would have been mildly negative, save for a GBP 28 mm tax credit. So, EV/Revenues is at 5.2x and EV/EBITDA is at 16x.

Relative Valuation

MANU’s valuation is very high compared to the two closest publicly traded comparables, Borussia Dortmund in Germany and Juventus in Italy (both major championship brands in major media markets). BVB.GR EV/Sales is 1.2x and EV/EBITDA is 4.1x, JUVE.IM has negative EBITDA and earnings; EV/Sales is 1.8x. (Bloomberg data) So, MANU is at 3-4x the relevant metrics of the comparables. Should it trade at a premium? Sure. But should it be so high? Probably not. It is easy to see 50% downside from here, just as it easy to see 50% upside on “vapor”, why not?

Recent Transfer of Robin van Persie

MANU spent GBP 30 mm in September 2008 to sign Tottenham striker Berbatov, who went on to become the top scorer in the league for 2010/11. Berbatov was benched for most of the 2011/12 season, and MANU lost the title to Manchester City on goal difference. MANU just paid GBP 22 mm to Arsenal for the 2011/12 league top scorer, Robin Van Persie. RVP is reportedly personally getting GBP 200k per week (GBP 10.4 mm per year). These are material expenses and material future liabilities that MANU has not (yet) filed with the SEC. You’d think that spending 20% of your EBITDA on a player and then promising him 10% for the year would be material. This situation illustrates a few of the problems highlighted here: constant capex spending on “stars”, high “key person” risks, lack of proper disclosure of material expenses and off-balance sheet liabilities.

Dearth of Natural Buyers

Who would own this stock? It is not clear to me who would be a natural, long-term, strong-hand buyer of the stock at these levels. One would have expected that a strong retail fan base would be good (as is the case with the Green Bay Packers “stock” or some of the Spanish teams) but the team IPOed in the US. While currently sizable enough, the non-US domicile and operations of the company, along with its problematic governance and looser financial control requirements, might keep some investors out. The drop in the IPO price to $14 from the initial range of $16-$20, along with Jefferies being lead left underwriter, makes me think that no one came to the party. The high borrow cost and lack of shares to short are also indicative of market pessimism.

Risks

- Irrational valuations can stay irrational for long periods of time
- Low float and high short interest make the stock prone to short squeezes
- One big name, well respected holder thus far (Soros Fund disclosed a stake at the IPO)
- The new Premiership TV contract not properly priced in, leading to a positive "surprise" forward projections
- UEFA Champions League advance (vs. the highly unusual group stage elimination last season) means more home games, thus "lapping easy comps"
- Stock trading on how the team is doing (and they usually do well)
- Stock purchases in the open market by an entity as a prelude to an outright exit by the Glazers

Disclosure: positioned to profit from a decline in the stock; the position can change at any time; information sourced primarily from the Securities Exchange Commission and other sources believe to be accurate; however the information here is presented without warranty for discussion purposes only.

Given that Federal Reserve Chairman Ben "Helicopter Make it Rain Dollar Bills" Bernanke just announced QE3 (quantitative easing) that sent the price of gold higher yesterday, we were sent an interesting infographic with some facts on everyone's favorite precious metal.

For years now, we've highlighted how many prominent hedge fund managers have owned gold in some capacity (either physically, or via proxies like exchange traded funds GLD or IAU).

A reader sent us an old article from Peter Lynch entitled "Use Your Edge." If you're unfamiliar, Lynch is a well-known fund manager that ran billions in Fidelity's Magellan Fund for a long time and is also the author of One Up On Wall Street and Beating the Street. Below we highlight some excerpts from the old article:

Invest In What You Know

Peter Lynch has long preached his old adage of "invest in what you know." Lynch writes,

"This is where it helps to have identified your personal investor's edge. What is it that you know a lot about? Maybe your edge comes from your profession or a hobby. Maybe it comes just from being a parent. An entire generation of Americans grew up on Gerber's baby food, and Gerber's stock was a 100-bagger. If you put your money where your baby's mouth was, you turned $10,000 into $1 million."

Warren Buffett advocates a similar approach in investing in "your circle of competence."

Let Your Winners Run

Lynch then goes on to touch on another old Wall Street Adage: "let your winners run, and cut your losers." He says that:

"It's easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds. If you're lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it. Let's say you have a portfolio of six stocks. Two of them are average, two of them are below average, and one is a real loser. But you also have one stellar performer. Your Coca-Cola, your Gillette. A stock that reminds you why you invested in the first place. In other words, you don't have to be right all the time to do well in stocks. If you find one great growth company and own it long enough to let the profits run, the gains should more than offset mediocre results from other stocks in your portfolio."

On Growth Stocks

And given the propensity for many investors to focus on growth stocks these days, we thought it worthwhile to share Lynch's thoughts:

"There are two ways investors can fake themselves out of the big returns that come from great growth companies. The first is waiting to buy the stock when it looks cheap. Throughout its 27-year rise from a split-adjusted 1.6 cents to $23, Wal-Mart never looked cheap compared with the overall market. Its price-to-earnings ratio rarely dropped below 20, but Wal-Mart's earnings were growing at 25 to 30 percent a year. A key point to remember is that a p/e of 20 is not too much to pay for a company that's growing at 25 percent. Any business that an manage to keep up a 20 to 25 percent growth rate for 20 years will reward shareholders with a massive return even if the stock market overall is lower after 20 years.

The second mistake is underestimating how long a great growth company can keep up the pace. In the 1970s I got interested in McDonald's. A chorus of colleagues said golden arches were everywhere and McDonald's had seen its best days. I checked for myself and found that even in California, where McDonald's originated, there were fewer McDonald's outlets than there were branches of the Bank of America. McDonald's has been a 50-bagger since."

On When to Exit the Market

Next, we wanted to highlight Lynch's rule for when to exit stocks. He says that,

"The only time I took a big position in bonds was in 1982, when inflation was running at double digits and long-term U.S. Treasurys were yielding 13 to 14 percent. I didn't buy bonds for defensive purposes. I bought them because 13 to 14 percent was a better return than the 10 to 11 percent stocks have returned historically.

I have since followed this rule: When yields on long-term government bonds exceed the dividend yield on the S&P 500 by 6 percent or more, sell stocks and buy bonds."

Applying his rule to the current market, we see that long-term (20 year) Treasuries currently yield around 2.52%. The S&P, on the other hand, currently yields around 1.9%, so Lynch would advocate staying in stocks.

Advice For Investing $1 Million

Lynch says to find your edge and put the money to work via the following rules:

- Know the reason you bought the stock
- Pay attention to facts, not forecasts
- Look for a risk-reward ratio of 3:1 or better (know how much you can lose)
- Be patient
- Enter early (investing in growth companies in the 3rd inning)
- Buy cheap stocks not because they're just cheap, but because fundamentals improve

Adam Weiss and James Crichton co-founded Scout Capital in 1999 and now manage around $4 billion. In their second quarter letter to investors, they touched on their new stake in Anheuser-Busch InBev (BUD) that they initiated in the first quarter.

They purchased shares thinking that domestic (US) beer demand was coming back and that the company would turn from paying down debt to share repurchases or dividends. Scout also felt BUD was cheap at a 7.5% free cash flow yield which was trading at a discount to other consumer franchises.

Their thesis centered on the discount stemming from two disconnects: 1. fundamentals of the industry and 2. capital allocation.

1. On fundamentals, they felt that the Street was "confusing cyclical effects for secular ones" as many investors had modeled the negative trend of beer volume into the future. Scout went the other way and assumed better employment would help US volumes.

2. On capital allocation, Scout's analysis pointed to Anheuser-Busch InBev being likely to allocate cashflow in a different direction than simply paying low coupon debt in order to keep its investment grade rating. The hedge fund thought BUD could buyback 7-9% of its shares per year, something that wasn't being priced in.

However, Scout also noted that the company's management is very smart with allocating capital as BUD instead chose to purchase Mexican brewer Grupo Modelo for $20 billion just before the end of the second quarter.

Scout writes,

"Factoring in expected costs savings, we believe the acquisition adds 10%-15% to ABInBev’s 2013 EPS on a full-year, pro forma basis. This doesn’t account for the tremendous international growth opportunity for Modelo’s flagship Corona brand as part of ABInBev’s global distribution network, which we estimate could contribute an additional 2%-4% earnings accretion. While the stock rose 10% on the news of the Modelo deal, our earnings estimates increased even more, and we believe BUD valuation is still too cheap relative to the growth and quality. The current free cash flow yield of 7.5% continues to represent a 20% discount to global consumer staples stocks with similar growth."

As if Anheuser-Busch InBev wasn't already in a dominant position in the beer market, this acquisition further entrenched their status.

Weiss and Crichton then concluded that,

"With the benefit of an improving U.S. beer market, upside to the cost and revenue synergies from the Modelo acquisition, and redeployment of excess cash flow toward buybacks, we believe ABInBev can compound free cash flow per share at around 15% for the next few years and generate total shareholder returns in the high teens, before any multiple improvement. On our 2014 free cash flow per share estimate of $6.50 and a peer-like cash flow yield of 6%, our two-year price target is $110 or 40% upside (including dividends) from the current level. BUD remains a core position."

Per their most recent 13F filed with the SEC, Scout disclosed over a $365 million position in BUD as of June 30th. At that time, it was their largest disclosed US equity long. This isn't the first time we've seen a hedgie's pitch on the brewer as Whitney Tilson's T2 Partners also made a presentation on BUD a few years ago.

Memos from Oaktree Capital's Howard Marks have gained somewhat of a cult following and rightly so. The investment manager often delivers pearls of wisdom to the investing masses and Warren Buffett has said that Marks' missives are some of his favorite reads. Oaktree's leading man is out with his latest memo entitled "On Uncertain Ground."

And with that title comes a harrowing line where Marks writes, "The world seems more uncertain than at any other time in my life." Such a warning can be quite ominous when you consider the history that Marks himself has seen over his lifetime.

Despite such warnings, Marks also intertwines some advice that many investors often forget: "in the investing world, doing nothing is doing something." Indeed, many great managers have attributed their great gains to simply having patience and doing nothing.

At the end of his piece, Oaktree's founder concludes that "Move forward, but with caution" is his investing mantra in the present day.

Barry Rosenstein's hedge fund JANA Partners has completely exited its position in Barnes & Noble (BKS). Per an amended 13G filed with the SEC this morning, JANA now shows a 0% stake due to trading on August 31st.

JANA originally took an 11.6% stake in Barnes & Noble back in April of this year and shares spiked 18% on the news at the time as investors hoped the activist firm would save the struggling bookseller. We also posted up their JANA's thesis on BKS.

The value here is in the company's Nook e-reader platform and that's what JANA's thesis centered on. John Malone's Liberty Media had also made a past investment in the company. Then shares spiked as high as $26 on news of a BKS strategic partnership with Microsoft.

Since then, shares have continually drifted down and now trade at less than half that recent peak at $11.xx. Back in April, JANA owned 7 million shares. In their most recent 13F filing which disclosed positions as of June 30th, they only owned 4.1 million shares. And now they've disclosed that they own 0 shares.

Or maybe JANA saw a more compelling use of the capital than BKS and decided to shift it there. Rosenstein will be presenting investment ideas at the Value Investing Congress in just over two weeks in New York City so we'll see what he pitches. You can register to hear Rosenstein's ideas (along with David Einhorn, Bill Ackman & more) via this link.

Tuesday, September 11, 2012

Ricky Sandler's Eminence Capital is having a good year as they finished the second quarter up 0.1% net and year-to-date at that time were up 14.8% net. This beats the S&P which returned 9.5% over the same period. In his second quarter letter to investors, Sandler explains why he likes Google (GOOG).

The search engine giant is currently their largest long position at 10% of equity, but they also own out of the money call options so adding in this delta-adjusted exposure gives them a 15% position.

The Q1 issue of our Hedge Fund Wisdom newsletter back in May (get it for free here) highlighted that GOOG was a consensus buy among hedge funds in the first quarter as shares dipped from $660 down to $565. After trading down/sideways in the second quarter, GOOG has ripped to new 52-week highs of $695 in the current quarter.

Why Eminence Likes Google

Sandler calls GOOG "one of the most compelling investment ideas we have ever seen" as he believes fundamentals will accelerate (though he also notes he's expecting near-term outperformance in the letter dated August 13th. Since then, GOOG is up just over 8%).

He points to the company's large moat in internet search as very attractive and also highlights the company's Adwords product as compelling as it provides a high return on investment for their customers.

The Eminence founder goes on to write,

"Despite its maturity, Google is still growing revenue at 25% per year in large part due to continued improvements Google is making to the product and the ongoing secular shift of advertising from offline to online.

In addition, Google has underappreciated new advertising platforms in mobile, display and video that are approximately 10% of net revenue and are growing at 100% annually. We expect these tailwinds to help the company continue its revenue growth at very high levels and to become increasingly visible to investors. In total, Google trades 10-11x our estimate of economic earnings for 2013 (ex-cash and after stock compensation expense), a staggeringly cheap multiple for a company that is growing as quickly and is as well positioned for the future as Google."

Fairholme Capital's Bruce Berkowitz has released numerous case studies about his investments in the past and one of his latest features his investment thesis on his second largest position: Sears Holdings (SHLD).

Fairholme's mantra is "ignore the crowd" and this investment certainly fits the bill. Sears has been one of the more shorted names among hedge funds (who have piled on as the retailer struggles). They simply wager that a turnaround is farfetched.

Berkowitz takes the other side of the trade and sides with Eddie Lampert, chairman of Sears (and a value hedge fund manager himself: ESL Investors/RBS Partners). This presentation is intriguing mainly because it provides both a variant view for the short sellers and a long case for value investors.

Per the filing, Lone Pine has revealed a 6.7% ownership stake in DNKN with just over 7 million shares. This is a brand new stake for the hedge fund as they did not report ownership in their most recent 13F filing detailing the portfolio as of June 30th.

As such, they've built their position between July and the present, with trading activity as recent as August 31st. That activity triggered the SEC filing as they crossed the 5% ownership threshold requiring disclosure.

Per Google Finance, Dunkin' Brands Group is "a franchisor of restaurants serving coffee and baked goods, as well as ice cream within the quick service restaurant segment of the restaurant industry. The Company operates its business in four segments: Dunkin’ Donuts U.S., Dunkin’ Donuts International, Baskin-Robbins International and Baskin-Robbins U.S. The Company develops, franchises, and licenses a system of both traditional and nontraditional quick service restaurants and, in limited circumstances, own and operate individual locations."

Playing catchup on some European regulatory filings, we find that George Soros' hedge-fund-turned-family-office Soros Fund Management has recently submitted a filing on Guinness Peat Group (LON: GPG). Due to trading on August 23rd and 24th, Soros Fund has revealed an 8.21% holding in GPG.

Per Google Finance: "Guinness Peat Group plc (GPG) is an investment holding company. GPG’s investments in range of sectors include financial services, food processing, building materials, property development and pub operators.

Its subsidiaries include GPG (UK) Holdings plc, which is an investment company; Coats plc, which is engaged in thread manufacture; Guinness Peat Group (Australia) Pty Ltd, which is an investment company; CIC Australia Ltd (CIC), which is engaged in property development; Gosford Quarry Holdings Ltd, which is a quarry operator; Touch Holdings Ltd, which is engaged in electronic products and services, and Turners & Growers Ltd (T&G), which is a fresh food wholesaler. On March 15, 2011, Turners & Growers Ltd acquired Inglis Horticulture Ltd (Inglis). In April 2012, GPG sold its remaining interest in Ashley House plc. In May 2012, it sold its remaining interest in Shepherd Neame Ltd. In July 2012, it sold its remaining shares in Daniel Thwaites PLC."

We wanted to highlight this because investing is a continual education and great investors are always looking for how they can refine their process. Learning from mistakes is a necessity and when you can learn from others' mistakes, you can often gain the knowledge without the battle scars.

Ackman's experience with C underscores two principles: 1. Invest in what you're comfortable with (or as Warren Buffett would say: stick to your circle of competence). And 2. If you can't sleep at night, sell.

Ackman on Why He Sold Citigroup

The Pershing Square founder writes, "Since the inception of Pershing Square, I had been opposed to making long investments in financial institutions. The inherent leverage, limited transparency, and regulatory risk discouraged us from investing in banks. Historically, most of our profits in financial institutions have been generated on the short side.

"We were attracted to invest in Citigroup beginning in April 2010 because of its strong balance sheet after the U.S. government-led recapitalization, the bank's low-cost deposit and liability funding, the favorable environment for making new loans, its conservatively marked balance sheet post-crisis, its dominant global-banking franchise, its strong senior management team who we believed was executing a strategy that made sense, and a price which we believed offered an attractive return when compared with the risk.

Over the course of our ownership, our predictions with respect to the bank's earnings power and improvements in its asset portfolio proved accurate. Over the same period, however, the regulatory and political environment for financial institutions deteriorated, sovereign credit and European financial institutions' creditworthiness weakened, and an important catalyst for value recognition was postponed when the government denied Citi the ability to return capital to shareholders. While the impact of these macro events affects nearly all businesses, they disproportionately and negatively affect financial institutions.

While we have constantly reassessed our decision to retain our stake in Citi over the last two years, at each previous moment of reconsideration, we elected to retain our shares because at successively lower valuations the stock price appeared to continue to offer sufficiently greater profit for the associated risks of the investment. In other words, while risk increased, the stock price quickly declined to reflect those risks, and the investment thereby continued to offer apparent compelling value versus a sale.

In recent weeks, I have reassessed our thinking on Citi. While I believe that our initial fundamental analysis was correct, we erred in overpaying for our stake because we did not demand a large enough potential profit from this investment in light of the inherent environmental uncertainties of investing in a financial institution. Recent events in the banking world - in particular, a large surprise derivative loss at JP Morgan and the recent LIBOR manipulation scandal - were the proverbial straws that broke this camel's back.

Our approach to risk management at Pershing Square relies in part on what I have deemed the 'Sleep at Night Test.' After one bad night's sleep thinking about Citi, I pulled the rip cord. While I still believe that Citi is a very cheap, well managed, high-quality banking franchise that is likely to increase in value over time, there are much easier ways for Pershing Square to make money. As a result, we redeployed the capital from the Citi shares into our new investment in Procter & Gamble. We thereby benefit with a large tax loss for our U.S. investors, reduced exposure to systemic risk in the portfolio, and fewer sleepless nights."

Takeaways From Ackman's Lesson

There are a few key takeaways here: Ackman had a clearly outlined thesis and constantly re-assessed both it and the risk/reward skew of the investment. He then recognized he made an error, knew exactly what that error was, and cut his losses.

Investors often fixate on the upside of a potential investment. Great
investors focus on the downside and the degree of risk/reward. In this
case, Ackman concluded that the risk he was taking outweighed the
potential upside.

Since in this case his error was "overpaying for our stake," this just goes to reinforce Warren Buffett's old adage: "price is what you pay, value is what you get." As always, price and determining a margin of safety are some of the most important aspects of the investment equation.

Bill Ackman will be presenting his latest investment ideas at the Value Investing Congress in NYC in 3 weeks along with David Einhorn, Barry Rosenstein, Jeff Ubben & many more hedgies. You can register to attend here.

As the market continues to rally and hit new 52-week highs, strategist Jeff Saut is out with his latest commentary prudently entitled, "Performance Anxiety." Saut has recently advocated that stocks would hit the 1450-1477 zone on the S&P 500. Under such a scenario, he questioned how under-invested portfolio managers would feel.

We've highlighted how many hedge funds have had low net equity exposure as of late, mainly due to various macro uncertainties (including the European crisis and potential China slowdown).

Hedge funds typically underperform during big rallies due to their hedged nature. But at what point does it start to become too costly and at what point do managers begin to worry?

Saut writes, "The concurrent performance anxiety would be legend because not only would you have performance risk, but also bonus risk and ultimately job risk." In an era where so many are judged on short-term performance, it's certainly worth monitoring. We tweeted back on July 27th that the max pain trade for hedge funds could be a move higher due to low net exposures.

But while many may be feeling pain near-term, Saut sees a correction ahead.

He writes, "I have been treating the June 4th 'low' as THE 'low' on a daily/intermediate-term basis. That said, the election year cycle suggests a 'high' is due this month with a pullback into mid/late-October that sinks the footings for the year-end rally. The catalyst for a decline should surface this week out of either the Fed meeting or the German constitutional court meeting. In any event, a near-term trading top is due."

So while Saut says a pullback is due, he hints that those experiencing performance anxiety should brace for a year-end rally as well.

Dan Loeb's Third Point Offshore Fund was up 1.8% for August and 7.3% year-to-date at that time. Now managing almost $4.7 billion, Third Point's August exposure report reveals that American International Group (AIG) is now one of their top five holdings.

The government has just announced that they will be selling $18 billion worth of their AIG stake, of which AIG will buyback $5 billion. This sale will allow the government to become a minority owner. We've analyzed the AIG situation in the brand new issue of our premium newsletter if you want to read why hedge funds have been buying.

Third Point joins the likes of Blue Ridge Capital, Tiger Management, and Fairholme Capital as owners of AIG. Loeb originally started a stake in AIG recently in the second quarter. However, it appears as though they've ratcheted up their position recently.

Their position in Kraft Foods was started in the past few months as well, as they're likely playing the impending spin-off catalyst there.

Third Point's Equity Exposure

At the end of August, the hedge fund was 70.6% long, -35.3% short, leaving them net long equities to the tune of 35.3%. Their net exposure is largely unchanged from the month of July, though they've slightly increased gross exposure. Their largest sector exposure continues to be Tech Media & Telecom (largely via their YHOO and AAPL stakes).

In credit, Third Point is net long 30.9%, with their largest exposure coming via asset backed securities. This is only a slight increase from the month prior.

Geographically, Third Point is net long the Americas 75%, net short EMEA -7% and net short Asia -10%. Month over month, this means Third Point was increased its short in EMEA and increased its long exposure to the Americas.

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